A Playbook for Investing in Alternatives and Diversifiers

Note: This article is part of Morningstar's December 2014 Guide to Better Investment Picking special report.

Over the past three days, we've cycled through the basic building blocks of every portfolio: U.S. stocks, foreign stocks, and bonds. You could easily add a dash of cash for liquidity purposes or to serve as an emergency fund and consider your portfolio complete. But some investors aren't content to stop there. They venture beyond plain-vanilla stocks and bonds in an effort to further diversify--to add something that could possibly hold its ground or even go up when the conventional assets in their portfolios are flagging. 

Such supplemental investments tend to ebb and flow in popularity, often based on whether they've performed well in the recent past. For example, real estate was the must-own asset class in the early 2000s, thanks in part to its strong performance following with bursting of the dot-com bubble. As real estate securities began to struggle amid the housing bubble bust, commodities took over leadership--albeit briefly--as the supplemental investment du jour. More recently, investors have been steering their diversification dollars to alternative investments like long-short and managed-futures funds. The attraction is that these hedgelike investments might (might) fare reasonably well at a time when stocks and bonds do not. 

But investors don't need all of these categories. Before investing, they should be sure to understand how these investments work, as well as their advantages and disadvantages. In addition, they should stay mindful of the fact that they're shoving aside more proven asset classes to make room for them. Here's an overview of some of the key asset types that confront investors aiming to diversify their equity and bond portfolios. 

Choice: Add Commodities?
Buying physical commodities can be logistically difficult because it requires you to take delivery of and store the commodity during your holding period. Because most investors don't have a place to stash pork bellies or barrels of oil, it's simpler to employ derivatives to provide exposure to various commodities, or to use a fund or ETF that buys these derivatives. 

Why add commodities: The key attractions of commodities investments are twofold. The first is as an inflation hedge: As you're having to pay higher prices for food, gas, and such, owning a commodities-tracking investment helps your portfolio benefit at the same time. That can help offset the pain of higher prices. Commodities have also been touted as a diversifier for equity and bond portfolios, though this point is debatable because commodities lost as much as stocks did during the financial crisis. 

Why not:Due to the vagaries of the commodities futures market--and specifically a phenomenon called contango--commodities futures may not precisely reflect commodities' prices at various points in time. Commodities can also be very volatile; investors seeking simple inflation protection can confront huge losses if they happen to buy at the wrong time. The tax treatment of commodities-tracking investments can also be onerous, depending on the vehicle you choose, and costs may be higher than what you'd pay for plain-vanilla stock and bond funds. Finally, the diversification benefits of commodities-tracking investments were called into question during 2008, when those investments lost nearly as much as the S&P 500. 

If you decide to add commodities:Before you invest in a commodities-tracking investment, first size up how much indirect exposure you might already have in your portfolio. Energy and basic-materials stock prices will not track commodities' prices directly, but they will be correlated. If you decide to add a commodities investment, a mutual fund, exchange-traded fund, or exchange-traded note will give you the most diversification benefit in a single shot. This article discusses Morningstar's favorite commodities-tracking investments. 

Choice: Add Gold?
Another category that investors sometimes look to for diversification is gold. They can go old school and purchase gold bullion themselves (and take responsibility for storing it), buy an exchange-traded fund that buys and holds gold bullion, or opt for a fund that buys stock in gold-mining companies. Each of these tacks carries its own pros and cons. 

Why add gold: Gold prices often head up in periods of geopolitical uncertainty, and gold prices have tended to be negatively correlated with equity prices over the long haul. That has made an investment in gold bullion (or a gold bullion ETF) a reliable diversifier. Gold-mining equities, meanwhile, have a higher correlation with the broad equity market than physical gold does, but their correlations with the global stock market are still lower than nearly any other equity sector. Moreover, it's possible to value gold-mining equities. Some investors also view gold as a hedge against inflation, though this is a topic of considerable debate. 

Why not: Because gold has no industrial uses. It's impossible to determine what the "right" price for gold is. Gold prices are also exceptionally volatile; if investors' timing is poor, as was the case with many buyers of gold bullion earlier in this decade, they can lose a bundle in short order. Moreover, gold's reliability as an inflation hedge is open for debate, though Morningstar's Mike Rawson demonstrates here that gold prices tend to be positively correlated with inflation. 

If you decide to add gold: Carefully considering why you're adding a gold investment can help you home in on the right vehicle. An ETF that buys gold bullion will generally be the best bet for investors in search of diversification; this article details some options for investors considering an investment in gold. 

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Choice: Add REITs?
Like commodities and gold, real estate investment trusts (REITs) are often posited as a way to diversify a plain-vanilla stock and bond portfolio. Investors can opt for exposure to individual REITs, buy an actively managed REIT fund, or buy an index fund that tracks a basket of REITs. 

Why add REITs: REITs have historically had a lower correlation with the broad U.S equity market than most other sectors. REITs are also viewed as a hedge against inflation: When prices at large are going up, the landlords who run the shopping malls, hotels, and apartment complexes that are owned by the REIT are generally able to to push through higher prices to their tenants. REITs are also required to pay out the bulk of their income to shareholders, making REIT yields high relative to other equities. 

Why not: Although their correlation with large-cap stocks is fairly low, REITs have historically had a high correlation with small-value stocks. So, if you have small-value exposure in your portfolio, a slice of REITs may be redundant. Investors also pay taxes on REIT income at their ordinary income tax rates, which is higher than the tax they'll pay on dividends from other equities. 

If you decide to add REITs: First, check your existing exposure to the sector using   Morningstar's X-Ray function. Many value-leaning diversified equity funds contain REITs. Moreover, if you have substantial equity tied up in your home or directly own other properties such as apartment buildings, think twice before layering on additional real estate exposure. (This article discusses that issue in greater detail.) If you decide to add a dedicated REIT investment, pay attention to your entry point; Morningstar's Market Fair Value graph for the real estate sector, based on our analysts' bottom-up valuations of the companies they cover, currently depicts the typical REIT as trading well above its fair value. This article discusses some of Morningstar's favorite real estate investments.

Choice: Add Alternative Funds?
With stock prices not particularly cheap and bond yields meager, many investors have flocked to alternative investments in the hope that they'll perform well at a time when conventional asset classes struggle. The alternatives asset class is a big tent featuring a broad array of strategies; among traditional mutual funds employing alternative strategies, the long-short equity and multi-alternative categories are the largest groups.

Why add alternative investments: The key reason to consider alternatives is to obtain diversification relative to stocks and bonds, though it's worth noting that various categories under the alternatives umbrella don't provide as much of a diversification benefit as others. 

Why not:Although hedge funds for the ultra-wealthy charge notoriously high fees, many mutual funds plying alternative strategies aren't exactly bargains themselves. That's a particularly big consideration given that many liquid alternatives funds have delivered meager returns since their launch. Alternatives may look better in a weak stock-market environment, but over the past five years, 10 of Morningstar's 13 alternatives categories have underperformed both the S&P 500 and the Barclays U.S. Aggregate Bond Index. 

If you decide to add alternatives: Because there's such a broad variation in strategies within the alternatives group, make sure you thoroughly understand a prospective investment's approach, how it's apt to behave in varying market conditions, and what it will add to your portfolio before buying in. Also, carefully consider the fees the fund charges. Morningstar's analysts explore all of these topics in their reports on individual alternatives funds, and this article calls out a small handful of Morningstar's favorites.